Inheritance tax (IHT) – once considered relevant only to the very wealthy – is increasingly a concern for more people. The nil rate band – or inheritance tax threshold – has been frozen for five years now, since April 2009, at £325,000.
This means more and more of taxpayers’ estates are becoming liable to IHT as a result of nothing more than normal asset price inflation.
Official figures recently confirmed this situation, showing an above trend increase in IHT receipt growth in 2012/13 of 8 per cent compared with a longer-term average of 7 per cent. Though the increase was only marginally above the historic norm, IHT receipts are likely to continue to grow at higher levels while the nil rate band remains fixed and asset values for properties, household savings and equity investments – which make up the bulk of most estates – go on rising.
There are of course many steps that people can take to reduce the value of their estates for inheritance tax purposes. Two of the most common ways are making gifts or placing assets in trust. But these have limitations and drawbacks, including that both must typically be done at least seven years before death in order to be exempt from IHT.
There is also an annual limit to the value of gifts of £3,000 (though there are some exceptions/additional gifts that can be made on top of this).
Placing assets into trust means an individual loses legal ownership of the assets and they may not be able to get it back if needed, or be unable able to change the beneficiaries once the trust is established.
Fortunately, there are other ways to reduce IHT liabilities – among them Enterprise Investment Scheme (EIS) funds. EISs were established by the government in the 1990s as a way of helping smaller unlisted UK companies secure growth capital. In exchange for investing in this relatively higher risk sector, individuals receive generous tax breaks, among them 100 per cent IHT exemption after the investment has been held for two years.
The two-year qualifying period for IHT exemption gives EIS investment an immediate and significant advantage over the more popular gifting and trust-based estate planning options and when you factor in the other benefits that EIS provide investors, the attractions are clear. Investments in EIS receive 30 per cent income tax relief, meaning the government is effectively funding almost one-third of an individual’s entire investment. The maximum an individual can invest annually in EIS is £1m, creating a potential income tax reduction of up to £300,000 – provided a person has an income tax liability equal to or greater than that amount.
EIS investments also grow free of Capital Gains Tax (CGT) and provide CGT deferral and loss relief. The latter allows an investor to offset any losses against their income tax for that year, which for a 40 per cent taxpayer means the maximum loss to which they would be exposed would be 42p in the pound in each individual EIS company investment.
In an EIS fund with a number of underlying company investments this feature is particularly attractive because even if the portfolio as a whole generates an attractive aggregate return, losses in individual companies can still be offset.
In spite of these clear attractions, recent data from the Office of National Statistics (ONS) showed that ‘unquoted shares’ – a category that includes EIS investments – accounted for only 2 per cent of the IHT relief claimed in the 2010/11 tax year.
When you also consider that ‘cash’ and ‘securities’ typically make up at least a quarter of estates, with the securities proportion rising to reach almost one-third of the assets in estates valued above £2m, it seems there is a planning opportunity for professional advisers and wealth managers to make more use of EIS funds in IHT planning.
Doing so would not only allow part of their clients’ estates to completely escape any IHT liability after two years but would also give rise to significant investment growth potential.
Of course, investing in unlisted smaller companies carries risks. But these risks can be substantially mitigated through in-depth bottom-up research and due diligence on underlying companies. EIS fund managers can also reduce risks by avoiding start-ups and selecting businesses and management teams that already have successful track records. Advisers can take a similar approach by choosing EIS fund managers with strong track records, diversified portfolios and lower-risk investment strategies.
For an estate planning strategy, EIS funds’ combination of tax-free growth potential, the retention of ownership and control of assets, coupled with a short two-year qualifying period for IHT relief, makes them a compelling option.
Susan McDonald is chairman of Calculus Capital
EIS BENEFITS AT A GLANCE
30 per cent income tax relief on a maximum investment of up to £1,000,000;
Provided shares are held for at least three years, profits on sales are Capital Gains Tax (CGT)-free (versus 28 per cent);
Investors can also take advantage of CGT deferral relief by reinvesting in EIS companies;
Capital loss relief of up to 45 per cent of net investment after income tax relief of 30 per cent, representing total tax reliefs of 61.5 per cent of the original investment;
IHT business property relief of 100 per cent of the value of investment may be applicable on death or gifting;
In the first 20 years since the launch of EIS, £8.6bn was raised for the benefit of 18,500 UK companies.
Source: Calculus Capital
